Using an LBO to Keep a Firm in the Family

By Mike Cohn

John Kramer's recent success created his current dilemma. As a building materials distributor, he had seen sales jump from $5 million to $20 million in five years.

Now, at age 60, John was pleased to have attracted the attention of a larger acquisition-minded distributor. After several visits, World Distributors offered John $4 million, an attractive price at 2.7 times book value.

Therein lay the problem. John's daughter, Carol, had been in the business for the past 10 years. In addition, his son-in-law and three other dedicated key employees had given John years of service. They were all like family.

Although World had promised to retain all employees — and even provide attractive financial incentives to the key group — John wasn't sure what to do.

When he told Carol and the four others of the purchase offer, they indicated they would like to buy the business instead. John was pleased, but he wasn't sure they could manage a buyout. Even if they got financing, the loan might cripple the company's growth.

The employee group hired our company to help them analyze and structure their proposal. They were surprised to learn they could do a leveraged buyout without any outside financing. Since World Distributors' offer was predicated on John's holding an installment note for $1.5 million, he agreed to do the same for the employee group. (Even if he hadn't, we found we could have arranged alternative financing from one of John's largest suppliers who was concerned about the possibility of losing John's account, and was eager to preserve this "independent" customer.)

John's accounting firm, and our valuation department, determined that a redemption of John's stock, in exchange for a $1.5 million note, represented a fair market valuation of the stock, and, on a per share basis, was consistent with previous shareholder transactions. John's installment note should be treated, for tax purposes, as qualified debt and thus avoid inclusion in John's estate under 2036(c).

The balance of the $4 million was constructed using an "offset" approach.

An offset approach uses tax-deductible compensation packages to "wrap around" the stock purchase or stock redemption agreement. Together these comprise the total deal between seller and buyer.

Offset techniques can also be used when assets instead of stock are acquired by the new owners. The asset purchase may be especially advantageous to the new owners. They get a new depreciation basis in the assets acquired, while the seller keeps the corporate entity.

In John's case, the present value of the three offset contracts totalled $2.5 million: a noncompete agreement, a nonqualified supplemental pension plan, and a five-year, $150,000 per year, consulting contract (until John turns 65). The present value of the deal matched the $4 million that World Distributors had offered, although John would actually receive $5.75 million in total dollars over the life of the contracts.

The structure of the offset methods were coordinated, providing for John and his wife's personal financial security with a long-term retirement income. John would receive $140,000 per year for ten years (from age 60 to 70) from the noncompete agreement, and an additional $140,000 per year for 15 years (beginning at age 65) from the supplemental pension plan. These payments would be continued for John's spouse in the event of his death.

For tax purposes, the payments for a noncompete agreement are considered ordinary income to the recipient and a deductible expense to the payer, amortized over the agreement's term. The acquisition of stock or company assets must be separate and distinct from the noncompete agreement. Compensation paid for the covenant (not to compete) must be distinguished from the price paid for the good will of the company. The agreement must also have an economic reality that reflects the seller's age, knowledge, and ability to harm the new owners by competing with them.

The supplemental pension plan is a nonqualified plan and can be distinguished from qualified retirement plans. Nonqualified plans can discriminate in favor of key executives by providing supplemental retirement benefits (rewards for past years of service), deferred compensation benefits (in lieu of current income), or salary continuation benefits. The appropriate nonqualified plan depends on many factors including the recipient's age and ability to receive Social Security benefits. These plans can pay benefits in addition to those received from the company's qualified pension or profit sharing plans.

Payments under these plans are deductible to the company, and subject to ordinary income tax treatment when received. Any funds informally set aside by the company usually remain an asset of the business. This may be an effective way to provide an "off balance sheet" transaction and help preserve the financial ratios of the business.

John accepted the key employees' offer. Carol, the new president, and her four new partners are working to expand the company. John is enjoying his new role as consultant, relieved to have turned over the day-to-day burdens of running the firm. Since the company no longer pays John's salary, the recovery of those funds helped create the dollars used to redeem John's shares and his other compensation "packages." The tax benefits to the business (in a 34 percent bracket) created an additional savings for the company. The impact on the company's cash flow is affordable, and the bank is pleased that management continuity is intact.

In a family business, the leveraged buyout doesn't necessarily originate with corporate raiders. Instead, the family-led LBO can invigorate the company, infuse it with new energy, and foster the company's growth.

Mike Cohn, president of The Cohn Financial Group, a financial planning firm in Phoenix, is author of the book, "Passing the Torch: Transfer Strategies for Your Family Business."

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May 1990


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